A look at bonds after peak easy money

Morgan Stanley Investment Management

09/09/21

Summary: Along with stocks, ETFs, and other types of investments, bonds are used by many investors, typically seeking to add income and diversification to a portfolio. Let’s explore potential opportunities in four key areas of the fixed income market that are less dependent on interest rates.

At the start of 2021, robust support from monetary and fiscal policy buoyed asset prices across markets. Today, as the battle against coronavirus persists, even as the global economy regains strength, investors are hotly debating inflation prospects and when the Federal Reserve will raise interest rates and taper asset purchases, and how that might affect the bond market outlook—as well as stocks and alternative investments. From a fixed income perspective, we see opportunities in four key areas of the market that are less dependent on interest rates: US high yield, mortgages and securitized assets, convertible bonds and emerging markets.

The sudden jumpstart to economies that all but ground to a halt last year created myriad bottlenecks. Price inflation spiked in many industries and marketplaces, as pent-up business and consumer demand overwhelmed still-disrupted supply chains. While this may prove transitory, sticky higher prices could drive up wages and create other long-term inflation risks.

Still, economic growth, inflation and policy support may all have already peaked in 2021. Central banks and government spending could remain supportive of markets, just less so than at the start of the year as we enter the next phase of the pandemic-driven economic cycle. The Fed, for example, probably won’t reduce its bond-buying program, known as quantitative easing, until this December or early in 2022, and we don’t expect it to start raising interest rates until mid-2023.

Disparate views about inflation and the pace and path of policy tightening abound. Which means that the months ahead will likely produce higher volatility, market dislocations and buying prospects for investors aiming to manage interest-rate risk through active management for higher yields and portfolio diversification.

US high-yield bonds as the economy improves

High-yield bonds—which have lower credit ratings than government debt or investment-grade corporate credit but offer investors higher interest income (at greater risk)—are one of the most appealing options in fixed income right now. High-yield bonds usually benefit from improving economic trends, including rising credit ratings and declining default rates. The potential for ongoing supportive monetary and fiscal policy could help boost the asset.

So, too, could reflation, or the return to global growth post-pandemic. Smart reflation trades could include lower-quality high-yield bonds and debt from smaller issuers, both of which are assets that may benefit in an improving economic cycle.

Mortgages amid US housing strength

Turning to securitized products in our bond market outlook, US residential credit may offer the best opportunity, given solid housing-market fundamentals amid strong demand. US home prices on average climbed 15% in the past year. Driving the increase were low mortgage rates and housing supply combined with growing demand from Millennials coming of age and forming their own households, and evolving work-from-home dynamics, based on National Association of Realtors’ May, 2021 data.

Bonds backed by assets in more pandemic-battered sectors, including those tied to aircrafts and small-business loans, may also offer attractive yields. Overall, the potential benefits of investing in the securitized market include low bond durations, higher yields and solid credit fundamentals.

Convertible bonds in an inflationary environment

As the economy recovers, the rise in inflationary pressure could bode well for convertible bonds—corporate debt that can be converted into common stock or equity shares—compared with other fixed-income assets in our bond market outlook. Shorter durations for the asset class may help mitigate the impact of rising rates on their valuations.

Despite turbulent performance in 2021, convertibles have led all fixed-income categories, with the Refinitiv Global Convertibles Focus Index up 3% year to date.1 Convertible bond issuances from companies in cyclical sectors, including materials, industrials, financials and energy, may present the best opportunities, despite a recent rebound in convertibles of certain growth companies and those that have reopened since pandemic lockdowns.

Emerging-market assets for higher risk and reward

Emerging-market debt could benefit from the pickup in vaccination rates in several of these economies, especially when compared with the outlook for Treasury yields to stay near zero. High-yield emerging-market credit may be more attractive than investment-grade debt, as the former offers a bigger cushion against rising yields in the more developed world and exhibits higher volatility (thus risk, and possibly, returns) compared to global growth.

There’s also opportunity in emerging-market currencies, given proactive central banks, even though the near-term risks are heightened by the dollar’s strength after the hawkish surprise at the June meeting of the Federal Open Market Committee, the policy arm of the Fed. Investors should be selective and focus on local currencies that mitigate inflationary pressures and haven’t already priced in too many rate hikes.

Bottom line: As always, though, portfolios should reflect personal goals and risk-tolerance levels, keeping in mind that diversification is a solid strategy in all market conditions.

 

The source of this Morgan Stanley article, Bond Market Opportunities After Peak Easy Money, was originally published on August 26, 2021.

  1. As of June 30, 2021

Diversification neither assures a profit nor guarantees against loss in a declining market.

There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and that the value of Portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). In addition to the risks associated with common stocks, investments in convertible securities are subject to the risks associated with fixed-income securities, namely credit, price and interest-rate risks. 

DEFINITIONS

The indexes shown in this report are not meant to depict the performance of any specific investment, and the indexes shown do not include any expenses, fees or sales charges, which would lower performance. The indexes shown are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

The Refinitiv Convertible Global Focus USD Hedged Index is a market weighted index with a minimum size for inclusion of $500 million (US), 200 million (Europe), 22 billion Yen, and $275 million (Other) of Convertible Bonds with an Equity Link.

IMPORTANT INFORMATION

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Prior to investing, investors should carefully review the strategy’s / product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.

The views and opinions are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment teams at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers. 

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.

Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness. 

This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. 

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Morgan Stanley Investment Management is the asset management division of Morgan Stanley.

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